The aerospace and defense industry found its largest base in the
U.S. with a fittingly impressive military budget. The U.S.'s global
leadership position requires it to maintain the capacity to respond
to the ever-changing national security environment.
Sequestration and spending cuts were expected to adversely affect
the performances of the defense behemoths that explicitly provide
products and services to the U.S. Department of Defense. In
reality, the defense players are doing well despite the fear of
Damocles' sword hanging over defense budgets and big-ticket
Budget Issues - the Sequester
In Apr 2013, the Obama administration proposed a defense budget of
$526.6 billion for FY14, down $0.9 billion from the FY13 annualized
continuing resolution level of $527.5 billion.
Again in May, an amendment to the FY2014 President's budget was
issued that included $80.7 billion (excluding prior-year
cancellations) for Overseas Contingency Operations (OCO), which is
essentially government-speak for foreign wars and war on terror
On Dec 10, 2013, the House and Senate negotiators have reached a
two-year budget agreement, mitigating about half the sequester cuts
expected to gouge the defense budget in fiscal year 2014. Upon
successful approval from both the House and Senate, any near-term
government shutdown will be averted.
The budget sequester that went into effect at the start of Mar 2013
and that has a direct bearing on the U.S. government's defense
spending is a function of the country's fiscal and economic
challenges. These cuts will not spare any of the defense majors
Lockheed Martin Corp.
Huntington Ingalls Industries Inc.
Offsetting the Sequestration Effect
Sequestration will cut some $1 trillion from the defense budget
over the next decade, according to The Washington Free Beacon. Yet,
the aerospace and defense industry is holding up well this year
thanks to technological innovations, big contracts, acquisitions
and growing commercial demand.
Since the domestic aerospace and defense sector is facing budget
cuts and a constrained spending environment, the industry is
looking for growth from international orders. Additionally, a
number of new emerging markets as well as developed nations such as
India, Japan, the United Arab Emirates, Saudi Arabia and Brazil are
boosting defense spending and generating business for the U.S.
aerospace and defense companies.
Moreover, these defense behemoths have diversified their businesses
to counter the effect of the sequester. Also, the complex military
programs being awarded to these companies much before the
across-the-board spending cuts came into force have somewhat
diluted the sequester impact.
Zacks Industry Rank
The Zacks Industry Rank relies on the same estimate revisions
methodology that drives the Zacks Rank for stocks. The way to look
at the complete list of 258+ industries is that the outlook for
industries with Zacks Industry Rank of #88 and lower is 'Positive,'
between #89 and #176 is 'Neutral' and #177 and higher is
'Negative.' Zacks Industry Rank for the Aerospace industry is at
#170 out of 258 industries, which puts it in the Neutral zone.
Earnings Review and Outlook
The third-quarter earnings season has been a testament to the
bullish trend in the defense sphere, defying sequestration and
budget cut woes. The earnings results of all the defense companies
in our universe, except two surpassed the Zacks Consensus Estimate.
The highest positive surprise of 37 cents came from Huntington
Ingalls while the lowest surprise of 2 cents was clocked by
L-3 Communications Holdings Inc.
). On the contrary,
Rockwell Collins Inc.
) missed the Zacks Consensus Estimate by 25.53% and 2.29%,
As of Nov 22, 2013, the aerospace sector's top and bottom line beat
ratio was 62.5% and 75%, respectively as compared to 42.1% and
65.4%, respectively, for the S&P 500.
For a detailed look at the earnings outlook for this sector and
others, please read our weekly
Huntington Ingalls Industries
From Mar 1, 2013 to date, there have been a number of share price
gainers with Huntington Ingalls Industries witnessing the highest
increase of around 93.0%, beginning Mar 1, 2013.
This company carrying a Zacks Rank #2 (Buy) ended the quarter with
a 46.25% positive surprise driven by solid program execution at
Ingalls Shipbuilding and Newport News Shipbuilding while it posted
a 25.63% positive surprise over the last four quarters on average.
Alliant Techsystems Inc.
) with a Zacks Rank #1 (Strong Buy) delivered a positive earnings
surprise of 16.53% this quarter and 13.39% over the last four
quarters. Lower interest expense and solid performance by the
Sporting business led to the upswing in earnings. The company
witnessed a share price appreciation of around 92.4%.
The company uses its cash in the best possible manner. Recently,
the company acquired Caliber Company, the parent company of Savage
Sports Corporation. The acquisition gives the company an
opportunity to bolster its leadership position in sporting and
security ammunition and accessories into the long guns market. The
acquired entity contributed $57 million to revenues in the reported
quarter. Apart from the company's cash deployment strategy, a
continuous in-flow of contracts makes it a Strong Buy.
Driven by operational improvements and capital deployment actions,
the earnings surprise this quarter for
) was a positive 13.53%. Surprise over the last four quarters was a
positive 21.16%. Beginning Mar 1, 2013, the company's share price
has risen approximately 51.8%. Raytheon also sports a Zacks Rank #1
Though the fourth quarter 2013 and full year 2013 estimates in the
table above depict a year-over-year decline, Raytheon looks good
with a continuous in-flow of contracts, introduction of new
products, completion of flight test series, consolidation and
earnings beat to boot.
The 2014 fiscal defense budget prioritized investments in Missile
and Space Systems, which is expected to bring in more contracts for
Raytheon. In addition, the company's focus on technological
advancements, as exemplified by its GaN systems, will make defense
solutions affordable and effective.
Raytheon is more focused on overseas sales to counter domestic
budget pressure. Best known for its missile defense systems, such
as the Patriot, Raytheon's international business is now expected
to garner close to 30% of total revenues this year. Earlier this
month, Raytheon received the green light from Pentagon for the sale
of some 15,000 anti-tank missiles to Saudi Arabia under two
separate deals with a combined value of $1.1 billion.
As of Sep 30, 2013, the company had a funded backlog of $22.1
billion that would convert into revenues in the near term. In
addition, the strong cash position, consistent dividend payment and
repurchase of shares make the stock look attractive. Indeed, the
company's strong cash position of $2.9 billion has been helping it
to acquire other firms. In June this year, the company acquired
Visual Analytics Inc. that will help the company in meeting the
data analytics, data visualization and information sharing needs of
Lockheed Martin, the foremost defense prime, experienced its share
price rise 56.1% since Mar 1, 2013. The positive surprise was
13.72% in this quarter and 14.00% in the last four quarters.
Lockheed Martin with a Zacks Rank #2 (Buy) has a strong liquidity
position and utilizes the cash in the best possible manner via
dividends and share repurchases. The company has lifted its full
year 2013 earnings guidance on its third quarter earnings
conference call, backed by the quarter's strong performance.
A key catalyst is the F-35 program, which is expected to account
for approximately 16% of 2013 revenue. The growing international
mix is also expected to increase to about 15% in 2014. Despite the
uncertainty plaguing the industry, the company has been able to
generate $15 billion in orders during the third quarter.
The Boeing Company
The Boeing Co.
) carries a Zacks Rank #2 (Buy). We note that it has surpassed the
Zacks Consensus Estimate by 16.88% in the past quarter driven by
solid operating performance fueled by higher aircraft deliveries.
Over the last four quarters, the company experienced an 11.96%
positive surprise on an average.
Despite various technical issues at its Commercial Airplane
Division, Boeing is seeing strong growth driven by rising demand
for air travel from the emerging markets and replacement (of older
aircraft) demand from the developed markets. Moreover, a recovery
from the financial crisis and consolidation within the industry has
enabled airliners to place big orders for new airplanes with
aircraft manufacturers like Boeing, Airbus, Bombardier and Embraer.
Boeing's share price soared 79.8% from Mar 1, 2013. Backlog and
deliveries are also robust. Total Defense, Space & Security
backlog was $70 billion as of Sep 30, 2013.
That said, we note that Boeing has mostly secured low-priced
contracts lately with the occasional high-value order attributable
to the ongoing sequestration in the U.S.
Good to Hold
From Mar 1, 2013 to date,
Northrop Grumman Corp.'s
) share price has boosted 65.3%. It has delivered a positive
earnings surprise of 8.84% this quarter driven by a lower share
count and strong operating performance. The earnings beat over the
last four quarters comes to 14.99%.
A steady flow of contracts which also include international orders,
a funded backlog of $23.4 billion, introduction of new products,
and the tendency of returning wealth to its shareholders drive this
Zacks Rank #3 (Buy) stock.
Although its share price increased 26.30% beginning Mar 1, 2013,
this Zacks Ranked #4 (Sell) stock ended the quarter with a negative
earnings surprise of 25.53% and an average negative surprise of
9.23% over the last four quarters.
Furthermore, Textron also lowered its 2013 earnings per share
guidance reflecting lower margins at Bell for manufacturing
inefficiencies along with labor disruptions, and lower aircraft
deliveries at Cessna.
) has been able to show a positive earnings surprise of 6.38% this
quarter, it experienced a 26.19% negative surprise over the last
four quarters on an average. The company's share price gained 11.8%
beginning Mar 1, 2013.
The company has a Zacks Rank #4 (Sell) and investors are
recommended to stay away from the stock for the time being.
Pros and Cons
In spite of the budget austerities and sequestration, defense
majors are riding high on foreign orders. These have to some extent
compensated for lower defense spending at home.
Undeterred by defense budget cuts, the big defense operators are
expanding their operations through acquisitions. Moreover, they are
busy restructuring their businesses. Also, they are keeping
themselves abreast in the technological front with new products
countering fresh competition.
The broad growth and development of the aerospace and defense
industry is tied to the defense budgets of different nations around
the globe, besides the U.S. The U.S. defense department has reduced
the defense budget significantly. These cutbacks will impact the
big contractors, as the lion's share of their revenues comes from
domestic defense spending.
Moreover, with the majority of revenue coming from government
contracts, the industry could be adversely affected by the
cancellation and delay of major government contracts. Again, with
more and more acquisitions being made by the defense players, there
is always the risk of completion, integration and financing of
The aerospace & defense industry has been a keystone of the
U.S. economy for decades and has provided well paying jobs for a
variety of skill levels. The U.S. aerospace industry continues to
contribute significantly to the country's economy and provides
capabilities vital for national security.
However, on the flip side, the industry's position is now
challenged by global competition, changes in technology, national
and worldwide economic conditions, and global policies affecting
defense, civilian and commercial aviation.
Moreover, any delay in the execution of orders would lead to an
imbalance between the cost and revenue structure. This would not
only hurt profitability but also lead to delays and even
cancellations of orders and/or programs.
On the whole, budget austerities still remain an overhang both in
the civil and military sectors. The companies that have little
diversification outside the U.S. are highly susceptible to spending
cuts from sequestration. On the other hand, those with an
international order book would find it less difficult to outwit
Admittedly, the sector enjoyed a solid earnings season,
technological progress, acquisition benefits and cost-cutting
efforts from individual companies. But these positives are held in
balance by defense budget austerities. This keeps us Neutral on the
sector for the time being.
ALLIANT TECHSYS (ATK): Free Stock Analysis
BOEING CO (BA): Free Stock Analysis Report
ROCKWELL COLLIN (COL): Free Stock Analysis
EMBRAER AIR-ADR (ERJ): Free Stock Analysis
HUNTINGTON INGL (HII): Free Stock Analysis
L-3 COMM HLDGS (LLL): Free Stock Analysis
LOCKHEED MARTIN (LMT): Free Stock Analysis
NORTHROP GRUMMN (NOC): Free Stock Analysis
RAYTHEON CO (RTN): Free Stock Analysis Report
TEXTRON INC (TXT): Free Stock Analysis Report
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